USDJPY and Stock Indices Correlation

 Correlation Between USDJPY and Stock Indices

Historically, the American indices (S&P 500, DJIA, NASDAQ) tend to move in the same direction as USD/JPY (the U.S. Dollar against the Japanese Yen).

⇄ Defining Correlation in Finance

In general, correlation between two variables expresses an average relationship supported by historical data. The correlation coefficient ranges from -1.0 to +1.0, where:

+1.0 indicates a perfect correlation, reflecting identical movements or directions.

-1.0 indicates a perfect negative correlation, reflecting exactly opposite movements or directions.

📈 US Dollar Correlation Coefficient

Comparing the USDX (U.S. Dollar Index) against the Dow Jones Industrial Average over the past 20 years yields a correlation coefficient of approximately +0.35. This positive value means that the U.S. Dollar and DJIA generally move in the same direction. However, since the coefficient is only 0.35, just 35% of DJIA movements are linked to movements in the U.S. Dollar.

There is a good reason for this.

As demand for American stocks rises, demand for U.S. Dollars increases as well, because dollars are required to purchase U.S. stocks. Below, we will explore why the Forex pair USD/JPY is more closely correlated with U.S. equities than any other currency pair.

📈 USD/JPY and American Stock Indices Relationship

The correlation between American indices and the U.S. Dollar is so strong that some investors consider the Dow Jones Industrial Average as an indicator of USD market sentiment.

This relationship can be explained as follows:

Explanation:

When investors want to buy U.S. stocks, they often borrow money in low-interest-rate currencies such as the Japanese Yen. The Japanese Yen and the Swiss Franc are ideal for this purpose. Here’s a closer look at how this transaction works:

(1) Investors who are bullish on the market borrow money in Japanese Yen, which traditionally has very low interest rates. They then convert the borrowed Yen into U.S. Dollars to purchase U.S. stocks. In this process, they buy U.S. Dollars today and repay the loan in Japanese Yen in the future. This transaction pushes USD/JPY higher.

(2) When investors turn bearish, they sell the U.S. stocks they previously purchased and use the proceeds in U.S. Dollars to repay their Yen loans. This means they exchange U.S. Dollars for Japanese Yen to pay back the debt. This transaction pushes USD/JPY lower.

Note that financial arbitrage accelerates this process, causing it to happen rapidly. As a result, arbitrage creates a direct correlation between USD/JPY and American stocks.

Chart: An impressive intraday correlation observed in early January 2016

📈 USDJPY and NIKKEI

Interestingly, before the 2007 crisis, USD/JPY and the Nikkei were inversely correlated. Since 2007, however, global stock markets have operated as a common pool of risks and opportunities. As a result, the Nikkei became correlated with the DJIA, which in turn is correlated with USD/JPY. Therefore, after 2007, the Nikkei and USD/JPY have shown a positive correlation.

🎯 Conclusions

The correlation between the Dow Jones Industrial Average and USD/JPY is strong, but the relationship between equities and currencies is more complex. This relationship can vary over time, influenced by factors such as interest rates, corporate earnings, global conditions, and more. As shown in the following chart, there are extended periods when USD/JPY and the Dow Jones move in the same direction, as well as shorter periods when they move in opposite directions.

Chart: Historical Correlation Between USD/JPY and Dow Jones Industrial

Source: ForexExperts.net, Google Finance

■ Correlation Between USDJPY and Dow Jones Industrial

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